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Turning uncertainties... into opportunities

Punjab National Bank’s fraud and waning investor confidence will weigh on state bank recapitalisation plan and government budget

Event

The Indian banking sector remains shaken by the Punjab National Bank’s (PNB) alleged fraud of about USD 2 bn that was revealed mid-February and would be the country’s largest bank fraud. Between 2011 and 2017, unauthorised bank guarantees would have been granted to billionaire jeweller Nirav Modi and related entities. As a result, the financial accounts of the 2nd largest Indian state-owned commercial bank (SOCB) would not reflect actual credit risks, thereby putting a shadow on banking regulation and raising doubts about the banks’ actual financial health. The PNB bank scandal has caused its share price to tumble by 40%, dragging with it the majority of state banks’ share prices.

Impact on country risk

The PNB bank scandal comes at a bad time. The broad USD 32 bn recapitalisation plan of SOCBs announced by the government at the end of 2017 had raised hope for India’s ailing banking sector. This scandal and negative market reactions are having adverse consequences. Firstly, the budgetary impact of rescuing banks is likely to swell further with the collapse of share prices and further deterioration of the poor reputation of dominating Indian SOCBs. It concerns the PNB first as its capital needs have been largely underestimated. More generally, an extra capital injection by the government will most likely be necessary to compensate for the probable lack of capital raised on the markets. As a matter of fact, investors who were initially expected to bring 25% of fresh capital in the bank bailout could think twice before investing their money into potentially riskier SOCBs. Consequently, the central government fiscal deficit target of the incoming 2018-2019 fiscal year – i.e. 3.5% of GDP – should again be revised upward.

Secondly, SOCBs might have higher non-performing loans (NPL) than officially reported (i.e. around 13% of total loans last June) and suffer larger write-off amounts of NPLs. It could frighten new investors

even though state support to big SOCBs is expected to remain. The Reserve Bank of India (RBI) has indeed recently reacted by tightening rules that accelerate recognition of large corporate debt defaults and by requiring higher transparency on SOCB accounts. In this context, disclosure of further banking scandals is not ruled out. Once again it highlights how deficient banking regulation, management within SOCBs and lending practices are. Recently, the RBI called for enhanced regulation and supervision on SOCBs where changes prove difficult to bring about. The PNB scandal might turn out to be the necessary evil India needed to boost banking reforms, especially under a reformist government. Still, experience shows that it might at best lead to slow reforms that take long before bearing fruits.

Finally, an enduring weak state banking sector might hinder credit growth and long-term GDP growth. It seems to be the main threat to PM Modi whose economic track record is so far deemed mixed mainly because of ill-timed and ill-prepared government reforms. In addition to some emerging political alliances in the opposition across various states, it might convince a popular and powerful Modi to hold snap general elections this year, i.e. earlier than spring 2019 as scheduled.